Dont leave risk to chance

Despite what many would have you think, managing risk is less about ticking boxes and more to do with recognising the extent of your knowledge.

Financial planning these days – at least as practised in some quarters – can be a peculiar business. You offer up a few details about yourself – such as age, number of dependents, earning capacity and your ‘appetite’ for risk – and a computer will spit out a list of monthly payments for you to make for various investments and insurances. You can then proceed with your life and, so long as you keep making the payments and the markets continue to provide their historical returns for your risk-determined investment style, you can look forward to a happy retirement, safe in the knowledge that your funds won’t run out (so long as you don’t outstay your welcome on this earth by too much of course). If this all seems a bit naïve, then that’s because it is. It may enable financial planners to churn out plans by the dozen, but none of them will deal with risk in any meaningful way.Investment risk tolerance If you really want to gauge your appetite for risk, you need to do it in the midst of a nasty, grinding bear market with a large chunk of your life savings apparently ebbing relentlessly away. Continuing to hold and even buy shares that have already fallen 30–40%, without any idea of where the bottom might lie, is very different to simply ticking a box marked ‘strongly agree’ alongside the statement ‘I want to maximise my returns and can tolerate short-term fluctuations in the value of my investments’. If you’re having trouble sleeping, try reading the Australian Risk Management Standard (AS/NZS ISO 31000:2009). In it you’ll find that one of the first steps, after identifying the stakeholders, is to identify all of the risks. This is actually impossible, but leaving aside this minor inconvenience, you can move on to the risk management options of avoiding, accepting, transferring, or ‘treating’ the identified risks. These days it seems that transferring risk to unsuspecting third parties is the flavour of the month. It’s the risk equivalent of pass the parcel and great if you can get away with it. But the trouble with transferring risks is that someone has to carry the can, and it can be hard to be sure that it won’t be you. Consider many fund managers. Aware that underperforming relative to other managers or the market is a sure way to get sacked, they march lockstep with each other and ‘hug’ the index. That is, they build a portfolio that closely resembles the All Ordinaries (or equivalent) index. In the process they transfer all the risk of financial loss in the event of a market collapse to their clients, who often pay high fees for the privilege. ‘I understand your portfolio’s down 28% this year, Mr Brown,’ they will explain, ‘but the market is down 26%, so you’re really not that badly off.’ If you want the returns of the index, then you might as well invest in a low-cost index fund (see our article on the subject dated 5 Dec 06). You’ll make sure you do actually track the index and, by avoiding expensive professional fund management fees, you’ll come out in front of the average investor.Risk Management 101 The first lesson in Risk Management 101 is that just because you can’t identify a risk doesn’t mean it isn’t there. But you can reduce the number of unknown risks by expanding your base of knowledge. Or, to put it another way, you’ll be less of a hostage to fortune if you fully understand the companies you invest in. Chris Browne, in his gem The Little Book of Value Investing, writes about the time component in risk. If your investments are highly leveraged (using a margin loan, for example), you are effectively giving someone else the right to say when the game is over, which is unlikely to be a time of your choosing. What’s more, using margin loans to buy shares in highly leveraged companies compounds risk significantly. Debt is a great accelerant – in both directions. Once again, the axiom about risk is that we are surrounded by it, whether we recognise it or not. Aviation has long accepted this. And, rather than seeking to identify all risks and threats to safety – which is impossible – airlines manage these risks at an operational level by training their pilots in ‘threat and error management’. This philosophy is based on constantly trying to identify operational threats whilst having multiple lines of defence. This process is directly transferable to investment, as set out in Table 1.

Table 1: Threat and error management

Aviation

Investment

Constantly seek to identify all possible threats and if possible avoid or transfer them.

Focus on good quality and conservatively financed businesses you are able to understand.

Know that undetected threats and errors are inevitable. Ensure mechanisms and procedures are in place to trap these threats and errors before they cause serious harm.

Invest with a margin of safety, paying a price below what you believe the business is worth.

Know that some threats and errors will still get past these defences. Ensure additional defences and procedures are in place to prevent them destructively cascading through the system.

Diversify your portfolio thoughtfully and use leverage sparingly.

We can also draw up a ‘Risk Matrix’ – with apologies to Donald Rumsfeld – to define our areas of knowledge (see Table 2). If we stick within the ‘know what we know’ box, then we are staying within our ‘circle of competence’. Also ‘knowing what we don’t know’ provides us with an extra defence by helping us define the boundaries of our ‘circle of competence’ more carefully. ‘Not knowing what we know’ isn’t a huge threat, but it may limit our investment opportunities.

Table 2: Risk matrix

Know

Don't know

Know

Know what we knowDefines our “circle of competence”

Know what we don’t know Opportunities to learn

Don't know

Don’t know what we knowMay limit investment opportunities

Don’t know what we don’t knowPotential high risk

Finally, there’s the box containing the things we ‘don’t know that we don’t know’. By definition, it’s impossible to recognise that you’re operating within this box. Hence, the only way to be sure of staying outside it is to stick within your defined circle of competence. You can help yourself here by expanding your knowledge, but remember that the bottom line is not the extent of your circle of competence but your ability to stay within it. This is not an area where you can pass the buck. You can try to transfer responsibility for your unknown unknowns to a financial planner, but given their unknown nature it would be a leap of faith (of unknown extent). And you can tick any boxes you like on a risk questionnaire, but it won’t mean much unless you truly understand what is meant by the statement ‘I want to maximise my returns and can tolerate short-term fluctuations in the value of my investments’.Rob Fitzherbert

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